'Discounting' made simple

Back by popular demand, Mike Howson hires Holmes and Watson to investigate the topic of discounting, relevant for ACCA paper 3.6

'I say, Holmes,’ said Watson at breakfast one morning, ‘how is it that accountants can foretell the future, whereas the rest of us can’t?’

‘What the deuce are you talking about, Watson?’ said Holmes, taking the new hookah pipe out of his mouth. ‘You must give me more to work on.’

‘Well, an old friend of mine, Bungee Jumper, dropped in at the club yesterday and showed me the accounts for one of his investments. They showed much lower profits than he had expected and, consequently, a lower dividend. It appeared that an important asset had been written down - I think the expression he used was ‘impaired’. He showed me the relevant note to the accounts and it said that the future cashflows to be generated by this asset had been discounted and compared with its book value; as the book value was greater, the asset had to be written down. But it’s dashed confusing how these chaps can work out what cashflows an asset can generate in the future.’

‘Watson, there are four separate issues here,’ said Holmes, taking a puff on his hookah. ‘The first is the estimation of the future cashflows generated by an activity. Accountants have extensive experience of business activities and think that reasonable estimates can be made.’

‘But surely, Holmes, there are too many examples of where the estimates have proved to be hopelessly wrong? The Channel tunnel, the Humber Bridge and the Scottish Parliament are just a few. The latter reputedly came in at ten times over budget.’

‘That is true, Watson, but those figures were not for the published financial statements. They were used as the basis for extracting money from lenders such as banks. The accounting profession now seems to think that such estimates can be shown on the Balance Sheet as the basis of valuations and that the auditor will accept them as true and fair. Various recent accounting standards require accountants to be reasonably certain as to the measurement of such figures. But, can an investment analyst rely on such figures when calculating accounting ratios? The advice that he will give must be flawed and will inevitably lead to financial problems.’

‘That seems only natural, Holmes.’

After another puff, Holmes continued.

‘The second issue concerns the interest rate to be used to discount the future cashflows. The principle is elementary and in some cases is a perfectly valid way of dealing with items in the accounts of a business. A good example is a lease to acquire a new machine. The total payments are known and so is the price that would have been charged if the item had been bought for cash. The difference is the total interest charge. And, because the period of the lease and all of the cashflows are known, it is possible to calculate the rate of interest that has been used in the lease contract. Is that clear so far, Watson?’

‘Yes, but I don’t see how it relates to Bungee’s situation.’

‘With the liability under a lease, the payments are known and so is the rate of interest. However, with any other future liability, assuming that the funds set aside to pay it off will be invested, what is the rate of interest that the investments will earn? Of course, if the rate of interest is known, it is possible to work backwards to find out what amount must be set aside. This amount is known as the present value of the future liability. The process is known as discounting and can also be applied to future cashflows generated by an asset to arrive at a valuation of that asset, as has been done in Bungee’s case.’
‘But, Holmes, how does one know what the interest rate will be in future years?’

‘Exactly, Watson. It has to be estimated. And, furthermore, it is unlikely to remain constant. The UK accounting standard on the subject of impairment, which you mentioned earlier on, says that “the discount rate should be an estimate of the rate that the market would expect on an equally risky investment and should be a pre-tax rate’. The international standard says that ‘the discount rate shall be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset”. This is a highly subjective matter as it difficult to assess the level of risk. And, incidentally, not all economists agree that it should be a pre-tax rate.’

Holmes paused, took a puff and sat back, waiting for the feeling of elation to subside before he continued.

’The third issue concerns present values. No project is undertaken in isolation and there are also likely to be surplus funds which should be invested. The proportions of all of these are constantly changing and therefore the overall interest rate used, averaged or whatever, will vary from year to year as well as from month to month. Accountants should at least consider the use of net terminal values. The final issue concerns what accountants are making the Balance Sheet into. While historical cost accounting shows the unexpired costs of a business’s assets, it never tries to show the value of the business, as this is such a subjective area that it is not possible to do so to everyone’s satisfaction. The value of a business can never be determined from an examination of its Balance Sheet, whatever convention is applied, and it is a waste of time to try. Furthermore, any attempt at valuation will involve a cost that businesses should be allowed to avoid. Admittedly, some estimations are made, such as for provisions for depreciation and liabilities, but these should be as prudent as possible.’

‘Holmes, it seems to me that there are too many estimates being made here. If these are the basis for the figures in the Balance Sheet, how can a shareholder possibly use the published financial statements as a basis for deciding whether he should hold on to his shares or sell them, let alone for an investment analyst to do more complex calculations?’

‘That is correct, Watson. There is so much subjectivity with estimates that there should be a health warning on the financial statements, although it must be said that some estimates are unavoidable, such as of the lives of the fixed assets. The real mystery is why the accounting profession relies so heavily on present values. It seems to me that this will end up rather like the Hans Christian Andersen story of the Emperor’s new clothes. That reminds me, we are meeting Lord Gulliball at noon. He has been rather led astray by an old adversary of ours…’